How to buy Chinese stocks after their rout

Investing in China requires more thought, less emotion

By

DawnLim

NEW YORK (MarketWatch) –– With the U.S. market teetering and European stocks sinking under the weight of debt fears, investors understandably have been looking for other countries to pin their hopes on.

What about China, whose economy has long captured the excitement of investors eager to capitalize on its rapid growth?

Chinese stocks ended higher Thursday, buoyed by talk that the national pension fund had bought a large chunk of shares to stabilize the market. Yet the day’s stock rise masked deeper fears that have pressured Chinese stocks over the past year.

The Hang Seng Index is down 15% so far this year, while the Shanghai Composite Index is off 8.1%.

China is a polarizing force for investors -- one that has been shrouded in emotion and rhetoric for much of this year. Weighing on investor sentiment: inflation jitters, concerns about its slowing economy, suspicions about sketchy accounting and fears about emerging-market growth stocks.

Yet the Chinese stock market, which tends to be characterized with broad brush strokes, is a nuanced one. With the variety of stocks and index-linked funds to choose from, investors can tap its diversity and hedge their risks. Rules of thumb: be careful with policy-sensitive sectors; pick shares of companies with transparent, open accounting; stay broad-based, and keep a lid on expectations.

1. Focus on transparent accounting

A number of accounting scandals have dampened faith in Chinese stocks. Look for companies that are more transparent with their books, which tend to be found on major global stock exchanges.

“The ‘supermodels’ have tended to go overseas,” said Jonathan Masse, portfolio manager at Baochuan Capital Management LLC. Disclosure standards are generally stricter on the Hong Kong and New York stock exchanges than on Shenzhen and Shanghai stock exchanges, he noted.

“Investors may feel more confident about companies listed on the main boards of stock exchanges as they are generally subject to more regulatory scrutiny than smaller boards,” such as the Nasdaq Pink Sheets, added Chin-Ping Chia, head of research for the Asia Pacific at MSCI Inc.

Be wary of so-called reverse-merger companies, said Andy Mantel, chief executive of Pacific Sun Advisors. Chinese companies that go public through the reverse-merger route combine with shell companies that are already listed, and so are able to avoid much of the scrutiny that comes with an initial public offering.

With the wealth of capital and more listed entities in the U.S. to serve as shell companies than in Hong Kong, reverse-merger companies are more likely to list on U.S. stock markets, Mantel added.

In contrast, the Hong Kong stock exchange forces such back door listings through a tighter disclosure process by considering them new offerings, unlike in the U.S., said Jamie Allen, secretary-general of the Asian Corporate Governance Association.

Because these companies enter through the back door, they are targets for short-sellers eager to jump on accounting irregularities — and their shares can be extremely volatile.

For example, when forestry company Sino-Forest Corp.
SNOFF
(TRE) was hit by fraud accusations by research firm Muddy Waters LLC in June, its stock plunged. Sino-Forest denied the accusations. That didn’t stop John Paulson’s Paulson & Co. hedge fund from unloading its entire stake in the company. But others, such Singapore-based investment group Richard Chandler Corp, took the stock’s tumble as a buying opportunity, and shares have since recovered slightly.

2. Pick dividend-paying stocks

“Companies that pay dividends provide an extra measure of objectivity,” said WisdomTree Investments’ Director of Research Jeremy Schwartz, “They can’t fake a dividend.”

Matthews China Dividend Investor Fund
MCDFX, -0.81%
is a mutual fund that focuses on dividend-paying companies in China and Taiwan. Its biggest holdings as of the end of July included China Mobile Ltd.
CHLKF, -1.20%CHL, -0.41%
and Cheung Kong Infrastructure Holdings Ltd. (1038) (CHH).

“Dividend payers generally have better management teams and are more shareholder-friendly,” said Rob Wherry, an analyst at investment researcher Morningstar Inc. “They tend to have better corporate governance and better balance sheets.”

3. Watch Beijing’s next move

Rising real estate and food prices have prompted the Chinese government to tighten the reins on inflation. Accordingly, tread carefully in sectors that could fluctuate as a result of uncertainty about the government’s next move, said Derick Leung, an analyst at Greater China Fund.

Greater China Fund
GCH, -0.30%
a closed-end fund, focuses on companies that generate revenue in yuan and Hong Kong dollars. This provides exposure to the yuan, which has recently appreciated against the U.S. dollar.

While real estate is traditionally an inflation hedge, Leung cautioned against keeping shares of Chinese property developers long-term. For example, Guggenheim China Real Estate ETF
TAO, -1.20%
which tracks an index of real estate companies and investment trusts, is down 11% so far this year.

It’s also the wrong time to own Chinese banks, J.P.Morgan analyst Adrian Mowat said in a note in July, projecting that loan growth would slow and credit costs would rise deeper into the tightening cycle.

The largest China-sector exchange-traded fund, iShares Trust FTSE China 25 Index Fund
FXI, -1.26%
tracks companies in the China equity market available to international investors. The ETF is off 14% this year, weighed down by big banks. With a 50% exposure to financials, its largest holdings include China Construction Bank Corp.
CICHF, +0.93%CICHY, -0.97%CICHY, -0.97%
and Agricultural Bank of China Ltd
ACGBY, -2.95%
(1288).

4. Be smart about tech

Search engine Baidu Inc.
BIDU, -3.64%
up 53% so far this year and web portal Sina Corp.
SINA, -0.62%
up 50%, have grabbed much of the excitement that investors and the media have about the Chinese Internet space.

But the prices these companies’ shares trade at are reflective of the optimism in these companies, and they are unlikely to provide much upside, said Morningstar senior analyst Dan Su.

Also, be wary of smaller companies trying to bring disruptive models into Internet spaces, Su said. Many haven’t proven that they will have a sustainable competitive advantage.

Newly-listed Chinese companies that provide technology-related products and services tend to move twice as much as the Standard & Poor’s 500-stock index
SPX, -1.42%
on a weekly basis, according to a MarketWatch analysis of firms newly listed on U.S. stock exchanges since the start of 2010. They swing more sharply and are riskier. Read full story here.

Two tech-oriented China ETFs of note have been focused on more mature companies.

Investors who want to take this approach can look at Guggenheim China All-Cap ETF
YAO, -0.68%
which tracks an index that limits any one position size to 5% of the portfolio, or SPDR S&P China ETF
GXC, -1.49%

Large-cap stocks are generally shares of companies with an over $10 billion market value. Big caps are seen by some as safer bets, but can yield lower returns.

The recent spate of accounting scandals, concentrated in smaller companies, has hit small cap stocks especially hard. Guggenheim China Small Cap ETF
HAO, -1.57%
is down 21% in 2011.

ETFs that focus on Chinese small caps — generally defined as shares of companies with a $1 billion to $2 billion in market value — have less exposure to financials, energy, and telecom companies. Chinese small caps have been more volatile than large caps over the last three years.

6. ‘China for chickens’

Although China ETFs fared better compared to broad emerging market funds in the last five years, concerns about slowing growth are likely to pressure Chinese stocks, Morningstar’s Oey said.

Hold a diversified emerging-market ETF, Oey said; it’s less risky than investing in a China-only ETF.

Investors can also consider multinational companies that are pumping resources into China.

Many of these companies are well-known in the consumer sector. For instance, Yum! Brands Inc.
YUM, -1.63%
reported in July that second-quarter profit jumped 10% on growth in emerging markets. LVMH Moet Hennessy Louis Vuitton
LVMHF, -0.20%
(LVMH) is also gaining market share in these developing areas, as is McDonald’s Corp.
MCD, -2.06%
Wal-Mart Stores Inc.
WMT, -1.93%
and PepsiCo Inc.
PEP, -1.15%
to name just a few.

“Global companies that tilt their business strategies towards China take some of the risk away from Chinese companies listed locally,” said Masse, of Baochuan Capital. “We call this strategy China for chickens.’”

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